As gilt yields rose sharply in response to the UK government’s planned tax cuts, the central bank announced on September 28 that it would make “temporary and targeted purchases” of UK government bonds at term until October 14 in order to restore market stability.
As the launch of the £65bn bond-buying program has led to lower gilt yields, investment consultants say LDI managers and pension funds should take steps to avoid a repeat the turmoil in the gilt market of the past week.
“I think whenever the BoE steps in to fix a problem, they will always follow up to say, ‘How can I make sure this problem doesn’t happen again?’ And inevitably that will mean changes in this market,” Barnett Waddingham partner Ian Mills told Pensions Expert sister title MandateWire.
A typical LDI pooled fund might seek to achieve between two and four times leverage depending on the maturity of the gilts it holds. We expect the levels of leverage offered in these funds to be lower in the future.
Lower levels of leverage
He says the “obvious immediate reaction” will be to limit the level of leverage that asset managers are able to offer in their pooled LDI funds.
“A typical LDI pooled fund might seek between two and four times leverage depending on the maturity of the gilts it holds. We expect the levels of leverage offered in these funds to be lower in the future,” continues Mills.
“In fact, we already know that one of the leading managers in this space is going to do it, and we expect the others to follow.”
Reuters reported on September 30 that BlackRock said it was reducing the leverage of its LDI funds.
Mills adds that if LDI managers reduce their leverage ratios, this will have implications for the investment strategy of pension fund clients who wish to remain hedged against fluctuations in gilt yields.
In order to remain hedged at a lower level of leverage, pension funds will, in some cases, have to provide “significantly more” liquidity directly to the LDI manager than in the past.
This means that plans will have to decide which assets they will sell from the rest of their investment portfolio in order to raise the cash required by their LDI manager, Mills notes.
“For some programs, this will represent a significant shift in overall strategy, as the consequence of selling growth assets to raise funds for LDI programs would be that their long-term expected return on investment will be lower, all things considered. otherwise equal in the future,” he adds.
Before systems can make the decision whether or not to stay hedged using LDI funds which forces them to hoard more cash and which impacts the rest of their investment strategy, they need to know how LDI managers will change their leverage ratios.
“Until we know this, we can only describe [to pension fund clients] in principle, those are the decisions that will have to be made and let’s prepare to make the decision as soon as we have all the information from LDI officials,” says Mills.
He adds that the pension regulator could consider requiring pension schemes to have “robust documented collateral management plans”.
“At the moment, there is no formal obligation for pension funds to [document their collateral management plans]although well-run programs have done it,” he says.
“I suspect that some of the pension schemes that did not pay out collateral did not have a clear plan and so were caught off guard when asked for more collateral than they expected to pay. “
As it stands, the only forms of collateral that can be used for most gilt derivative contracts and repurchase agreements are cash or gilt.
Mercer partner Hemal Popat told MandateWire that part of the “solution” would be to use other types of collateral in addition to gold and cash.
“Allowing the use of corporate bonds as collateral to support hedging transactions in LDI mandates could help, as it will provide an additional source of liquidity for such transactions,” he said.
“A number of complexities will need to be resolved, however, to allow this to happen.”
Like Mills, Popat also expects to see the leverage ratios of LDI mutual funds move to lower target levels and the ranges in which they operate shrink.
“A change in fund structures is happening in real time. And I understand that most pooled LDI fund managers are looking to implement these changes before October 14th because they want to be more resilient at the end of [BoE’s gilt market] support operations than they were a week ago,” notes Popat.
He adds that the BoE hopes there will be “substantial movement” in terms of reducing the leverage of LDI in the UK pension sector by October 14.
“It remains to be seen whether it will be possible to complete this exercise by October 14. We and others are working at lightning speed to ensure this is the case, but we will need to take stock sooner to see exactly where we are,” he said.
BoE expands measures to shield schemes from market turmoil
The Bank of England has announced additional measures to support pension funds in the current market turmoil, including an increase in the size of its daily gilt auctions and a temporary initiative to ease liquidity pressure on schemes holding pensions. liability-based investments.
However, Popat notes that leverage can only be reduced by unwinding hedges, where ultimately the hedge counterparty will have to sell gilts, or alternatively by delivering cash and other assets into an LDI mandate for the recapitalize.
“So however this plays out, there will be significant asset sales needed either by pension funds or their counterparties to manage this transition to a low-debt world,” he says. .
“At the end of this adjustment period, I expect there will be a more resilient LDI system in place and that pension funds will continue to use LDI strategies as they have done in the past. , but probably with lower coverage ratios on average than before.”
This article originally appeared on MandateWire.com